Finding the next Nvidia

US chipmaker Nvidia (NVDA) is all the rage in stock markets. This week, the company briefly entered the exclusive club of stocks valued at US$1 trillion or above.

Only seven other US companies have ever achieved this mark. And Nvidia is now valued close to Amazon (AMZN).

For a company that isn’t a household name, it’s an extraordinary achievement. What’s even more extraordinary is the way in which it’s achieved the milestone.

Last week, after posting record sales, the company rose 24%, or US$184 billion in market value, in just one day. That one-day gain was larger than the market caps of companies like Disney (DIS), Nike (NKE), and Netflix (NFLX). And the market value jump has only ever been exceeded by two other companies: Amazon and Apple (AAPL) (both with US$191 billion gains).

Nvidia’s stock is up 164% this year and more than 10,000% over the past decade.

Why is there such excitement over Nvidia? Well, the company designs semiconductor chips that are made of silicon slices which contain certain patterns. These chips have billions of switches that process complex information simultaneously. And now they are central to many Artificial Intelligence (AI) functions: everything from ChatGPT to image generation.

It’s the AI bit that has captured the imaginations of investors. As an analyst noted of Nvidia:

“There’s a war going on out there in AI, and Nvidia today is the only arms dealer out there. So as a result we’re seeing this huge jump in revenues.”

Of AI’s potential, Bill Gates has this to say:

“The development of AI is as fundamental as the creation of the microprocessor, the personal computer, the Internet, and the mobile phone. It will change the way people work, learn, travel, get health care, and communicate with each other. Entire industries will reorient around it. Businesses will distinguish themselves by how well they use it.”

Nvidia is now being valued at around 35x sales and it’s invoked comparisons to the high valuations of the 2000 tech bubble.

Identifying stocks with strong growth potential

While much of the commentary centres on the market implications of Nvidia’s rise, less discussed is how investors might go about finding the next Nvidia. Not the next tech darling necessarily, but the next growth stock that will compound earnings over a long period and eventually be recognised by the market for its business performance.

One way to do this may be termed the Morningstar method. It involves focusing on companies with wide economic moats that can help them fend off competitors. A moat can allow a company to consistently achieve higher margins than its competitors and earn returns in excess of its cost of capital. It can also enable a company to excel in any environment.

Morningstar’s Mark Lamonica says to identify moats requires an investor to be a student of business.

"You must understand the sector or industry that the company operates in and what factors influence customer behaviour,"

This is a skill you can develop, he says.

"Start with an everyday product that you use and make a list of competitors that offer the same or similar products. Think about substitutes as well as direct competitors. Think about the things that influence your own behaviour as a consumer. What would it take for you to switch to a different provider? What would cause you to buy more or less of the product? What does it take for the company to keep you as a customer – constant sales, constant marketing, constant improvements in the product? Think about how that good or service is produced. What are the different things that may influence the cost of producing that good or service. Does producing it at scale make it cheaper? Is it reliant on inputs with shifting prices? Finally, think about the ease with which new competitors can enter the market. Are there low barriers to entry or are there structures in place to prevent competition like government licenses or patents.”

Buying a basket of stocks

Identifying and buying a growth stock in one thing, holding onto it for the long term is another.

Take Nvidia. To get the extraordinary gains of this year, you would have had to endure a painful 64% drop in the stock price between November 2021 and October 2022. And a 54% fall in 2018. The path to Nvidia joining the US$1 trillion club has been far from smooth.

This is a common story with growth stocks. For example, Amazon lost almost 95% of its value during the 2000 tech bust. The stock had a 54% drop in 2005-2006, a 58% decline in 2008, and 5 separate instances of 25% or more in losses since 2009.

Nvidia and Amazon aren’t isolate examples. Portfolio manager Ben Carlson notes that since 1980, more than 40% of all companies in the US stock market have had a decline of 70% or worse without recovering.

There aren’t many investors who can stomach these types of losses and hang on. Especially if you don’t know whether the stock will ever come back or not.

Not only are growth stocks often hard to stomach, but choosing the right ones can be difficult. For instance, you may think the outlook for gene therapy looks amazing and choose a stock to play the theme. It can turn out that you were right on the theme but wrong on the stock, and a competitor got the jump on them to become the leader in the field.

One way to avoid this problem is to buy a basket of stocks to play a stock market theme.

That’s what GQG CIO Rajiv Jain has chosen to do with AI. Jain told the recent Morningstar Investor Conference in Australia that he believes artificial intelligence (AI) will be revolutionary and the large cap tech stocks such as Alphabet (GOOG) are likely to be winners from this revolution. He says there are 400 AI startups and it’s impossible to pick who will be the ultimate winner. Yet it does seem to him that the larger companies should do well from it, especially in an environment of higher interest rates, which make it harder for startups to get off the ground and scale.

Buying a basket of stocks is one way to play a favoured stock market theme. Another is simply to buy an ETF. Thematic ETFs are gaining favour with investors for this reason. For instance, Australian investors can invest in AI through the Betashares Global Robotics and Artificial Intelligence ETF.

The benefit of buying a basket of stocks is that you aren’t reliant on one stock for performance. The downside is that you still have concentrated exposure to a group of stocks. And it may not prevent the stomach-churning volatility often associated with growth stocks and themes.

Buying the whole market

There’s another way to get access to growth stocks and that’s through buying a broad market ETF or index. Buying an ASX 200 ETF is essentially a bet on progress and innovation. As legendary Vanguard founder, John Bogle, said:

“Don't look for the needle in the haystack. Just buy the haystack.”

The greatest stock picker of all time, Warren Buffett, seems to agree. Upon his death, he’s advised the trustee for his wife’s benefit to put 90% in a low-cost S&P 500 index fund and the rest in short-term government bonds.